The Loanable Funds Market Unit 4, Section 2

Interest-Rate-Investment Relationship Marginal Benefit : expected rate of return on VS. Marginal Cost: interest rate which must be paid back on borrowed funds https://econ.video/2019/01/17/espn-30-for-30- broke-risky-investments/

Investment Demand Curve This curve shows the relationship between The expected rate of return (r) This is based off of the real interest rate The amount of the investment

Shifters of the Investment Demand Curve Cost of capital goods and maintenance Ex. High electricity costs for certain machines would decrease the investment demand Business taxes Ex. Firms base returns on the AFTER tax value. This means if taxes are higher, the return would be lower, decreasing the investment demand. Technology Changes Ex. More efficient machines mean would increase investment demand Stock of capital goods If the overall economy has too many of a certain machine or technology, the value of the product decreases, lowering the investment demand for the specific machine of technology Expectations Ex. Usually investment is on capital or research of a technology that will bring benefits in the future, so the investment would rely on the expectations of the business or company into the future.

The Loanable Funds Market The market representing savers and borrowers in the economy

The Loanable Funds Market Supply: the amount of loanable funds in the economy These are supplied by the savers in our economy Demand: the demand for loanable funds in the economy These are demanded by the borrowers in our economy There is a correlation between the demand for investment. If the demand for investment increase, the demand for loanable funds increases & vice versa

The Loanable Funds Market Equilibrium – Qs = Qd Because we are evaluating lending money in the economy, the “price” for the funds would be the REAL interest rate. Creates efficiency, more profitable projects are funded AND lenders with more reasonable rates receive business Leads to greater long-run economic growth

The Loanable Funds Market Shifters: Supply – Incentives to save more money would increase the amount of loanable funds available. If money is taken OUT of savings, the supply would decrease Could also be influenced by foreign investors as they may deem a country more or less “safe” If we have a government SURPLUS, money would be put into national savings and pays off national debt Demand – changes in perceived business opportunities & investment Government Spending Don’t forget about Crowding Out

Real interest rate = nominal interest rate – inflation rate Interest & Inflation Changes in expectations about inflation can shift both supply and demand for loanable funds The true cost of borrowing/payoff of lending is the REAL interest rate, not nominal Real interest rate = nominal interest rate – inflation rate Expectations about inflation rates are based on recent experience, so interest rates lag behind true inflation trends To see why, suppose a firm borrows $10,000 for one year at a 10% nominal interest rate. At the end of the year, it must repay $11,000—the amount borrowed plus the interest. But suppose that over the course of the year the average level of prices increased by 10%, so that the real interest rate is zero. Then the $11,000 repayment has the same purchasing power as the original $10,000 loan. In effect, the borrower has received a zero-interest loan.

NIR = expected inflation + real interest rate Irving Fisher was known for Monetarist Theory & his work with the REAL interest rate to NOMINAL interest rate. Fisher Equation – NIR = expected inflation + real interest rate OR i = r + πe The Fisher Effect Do and So are the demand and supply curves for loanable funds when the expected future inflation rate is 0%. At an expected inflation rate of 0%, the equilibrium nominal interest rate is 4%. An increase in expected future inflation pushes both the demand and supply curves upward by 1 percentage point for every percentage point increase in expected future inflation. D10 and S10 are the demand and supply curves for loanable funds when the expected future inflation rate is 10%. The 10 percentage point increase is expected future inflation raises the equilibrium nominal interest rate to 14%. The expected real interest rate remains at 4%, and the equilibrium quantity of loanable funds also remains unchanged.

Comparing Interest Rates in the SR

Interest Rate in the Long Run In the long run, changes in the money supply don’t affect the interest rate In the long run, an increase in the money supply causes an equal increase in price levels, so there would be a rightward shift in MD – raising the interest rate back to equilibrium This is the result of a shift in supply in the loanable funds market, as prices rise. In the long run, the loanable funds market determines r, as it is the level at which supply meets demand for loanable funds – which meets potential output.

Long-Run Determination of the Interest Rate